Boynton SM Ch.17

CHAPTER 17
AUDIT ING THE INVESTING AND FINANCING

CYCLE
Learning Check
17-1.
Investing activities represent the purchase and sale of land, buildings, equipment, and other
assets not generally held for resale. In addition, investing activities include the purchase and
sale of financial instruments not intended for trading purposes (discussed in chapter 18).
Financing activities include transactions and events whereby cash is obtained from or repaid
to creditors (debt financing) or owners (equity financing). Financing activities would
include, for example, acquiring debt, capital leases, issuing bonds, or issuing preferred or
common stock. Financing activities would also include payments to retire debt, reacquiring
stock (treasury stock), and the payment of dividends.
17-2. When auditing the investing and financing cycles auditors typically address the following
issues:
What assets are necessary to support the operations of the entity, and what are
managements long-range plans for growing the entitys asset base? Answering this
question assists the auditor in developing expectations of long-term assets needed to
support operations.
What assets were acquired, or disposed of, during the period? Answering this question
confirms the auditors expectations regarding assets needed to operate effectively. It also
assists the auditor in developing expectations of regarding financing activities.
How were newly acquired assets financed? Answering this question completes the audit
of the investing and financing cycles.
These cycles are often audited together due to the strong connection between asset
acquisition and the financing of those assets.
17-3. Investing activities are critical to a company in the hotel industry as facilities are the primary
productive asset. The location and quality of hotel facilities are directly related to revenues
and represent a substantial proportion of the asset side of the balance sheet. Due to the longterm nature of these assets they are usually financed with long-term mortgages.
Alternatively, buildings are only necessary to house the process of computer assembly and
often these facilities may be leased rather than purchased. A computer assembler may even
consider an operating lease rather than a capital lease. The core processes for the computer
assembler are marketing and purchasing and long-term assets are primarily a support
function.
Solutions Manual to Modern Auditing: Copyright
2005, John Wiley and Sons, Inc.
17-1
17-4.
a.
Audit objectives for plant assets can be summarized as follows:

Specific Audit Objectives
Transaction Objectives
Occurrence. Recorded acquisitions of plant assets (EO1), disposals of plant assets (EO2), and
repair and maintenance transactions (EO3) represent transactions that occurred during the year.
Completeness. All acquisitions of plant assets (C1), and disposals of plant assets (C2), and
repair and maintenance transactions (C3) that occurred during the period were recorded.
Accuracy. Acquisitions of plant assets (VA1), disposals of plant assets (VA2), and repair and
maintenance transactions (VA3) are accurately valued using GAAP and correctly journalized,
summarized and posted.
Transactions for depreciation expense are properly valued (VA5).
Cutoff. All acquisitions of plant assets (EO1 and C1), and disposals of plant assets (EO2 and
C2), and repair and maintenance transactions (EO3 and C3) have been recorded in the correct
accounting period.
Classification. All acquisitions of plant assets (PD1), and disposals of plant assets (PD2), and
repair and maintenance transactions (PD3) have been recorded in the proper accounts.
Balance Objectives
Existence. Recorded plant assets represent productive assets that are in use at the balance sheet
date (EO4).
Completeness. Plant assets balances include the effects of all applicable transactions during
the period (C4).
Rights and Obligations. The entity owns or has rights to all recorded plant assets at the
balance sheet date (RO1).
Valuation and Allocation. Plant assets balances are stated at cost (VA4), less accumulated
depreciation (VA5), and are written down for material impairments (VA6).
Disclosure Objectives
Occurrence and Rights and Obligations. Disclosed plant and equipment events and
transactions have occurred and pertain to the entity (PD4).
Completeness. All PP&E disclosures that should have been included in the financial
statements have been included (PD5).
Understandability. All PP&E information is appropriately presented and information in
disclosures is understandable to users (PD6).
Accuracy and Valuation. PP&E information is disclosed accurately and at appropriate
amounts (PD7).
b.
The audit objectives for natural resources and intangible assets would be quite
similar to those for plant assets. The natural resource issues are almost identical and
the auditor needs to consider the issues associated with depletion of assets. With
respect to intangible assets, there are significant issues associated with the valuation
of intangibles at acquisition, the amortization of intangibles, and the impairment of
intangibles.
17-2
17-5.
a.
Following are several examples of analytical procedures and how they might be
used to identify potential misstatements.
Ratio
Fixed Asset Turnover
Total Asset Turnover
Depreciation Expense
as a Percent of
Property, Plant and
Equipment
Repair Expenses to
Net Sales
17-6.
17-7.
Audit Significance
An unexpected increase in fixed asset turnover may indicate
the failure to record or capitalize depreciable assets.
An unexpected increase in total asset turnover may indicate the
failure to record or capitalize depreciable assets.
An unexpected increase or decrease in the depreciation
expense as a percent of depreciable assets may indicate an
error in calculating depreciation.
An unexpected increase in repair and maintenance expense
may indicate the possibility that assets that should be
capitalized have been expensed.
b.
Inherent risk may be low for the existence assertion for plant assets as they are not
vulnerable to theft and they are easy to observe. However, inherent risk may be
moderate to high for issues of completeness associated with the recording of capital
leases, the existence of various capitalized expenditures, or with the accounting
estimate associated with depreciation expense.
c.
The same system of internal control that governs normal day to day expenditures
also applies to the acquisition of plant assets. Additional controls that might not
apply to routine expenditures include the fact that due to the size and long-term
implications of acquisitions of plant assets, they are normally subject to a capital
budgeting process and review by the board of directors (or committee of the board).
Depreciation policies and useful lives should be reviewed by a disclosure committee.
a.
In a first time audit, the auditor undertakes an investigation of the beginning balances
and the ownership of major units of plant currently in service. In a recurring
engagement, the auditor only has the responsibility for determining that the
beginning balances agree with the adjusted balances in the preceding year's working
papers.
b.
The substantive tests that apply to three or more assertions are:

Perform analytical procedures.
Vouch plant asset additions to supporting documentation.
Vouch plant asset disposals to supporting documentation.
Review entries to repairs and maintenance expense.
Inspect plant assets.
Examine title documents and contracts.
Review provisions for depreciation
a.
Applying analytical procedures involves the use of ratios and other analytical
techniques. This test applies to all assertion categories except rights and obligations.
17-3
b.
Inspecting plant assets generally involves physical inspection of additions to plant

assets and touring other plant assets while being alert to evidence of additions and
disposals not included on client schedules and to conditions that bear on the proper
valuation and classification of plant assets. This test also relates to all assertion
categories except rights and obligations.
c.
Examining title documents and lease contracts involves the scrutiny of these
documents for such information as ownership rights and contract terms. This test
relates primarily to the existence or occurrence, rights and obligations, valuation or
allocation, and presentation and disclosure assertions.
d.
Vouching plant asset additions involves testing from the accounting records to
supporting documentation. This test provides evidence for the existence or
occurrence, rights and obligations, and valuation or allocation assertions.
17-8. The procedures that may be useful to the auditor in determining whether all plant asset
retirements have been recorded are:
Analyze the miscellaneous revenue account for proceeds from sales of plant assets.
Investigate the disposition of facilities associated with discontinued product lines and
operations.
Trace retirement work orders and authorizations for retirements to the accounting
records.
Review insurance policies for termination or reductions of coverage.
Make inquiry of management as to retirements.
17-9
a.
In reviewing depreciation entries and computations, the auditor seeks evidence on

the reasonableness, consistency, and accuracy of depreciation charges. The factors
pertaining to reasonableness include (a) the client's past history in estimating useful
lives, (b) the remaining useful lives of existing assets, (c) the gains and losses
experienced on the sale of assets, and (d) industry practices. For consistency, the
auditor can obtain information about the depreciation methods used from a review of
schedules and inquiry of the client. The accuracy of depreciation charges can be
verified by recalculation.
b.
The auditor should evaluate whether the client has appropriately accounted for the
impairment of plant assets when there has been a material change in the way an asset
is used, or when there has been a material change in the business environment. The
evidence to evaluate impairment is based on an estimate of the undiscounted future
cash flows from the asset. Based on the criteria established in FASB 121, an auditor
should consider that the value of an asset is impaired when the undiscounted future
cash flows from an asset are less than the book value of the asset.
17-10. a.
The financing cycle includes transactions and events whereby cash is obtained from
or repaid to creditors (debt financing) or owners (equity financing). Financing
activities would include, for example, acquiring debt, capital leases, issuing bonds,
or issuing preferred or common stock. Financing activities would also include
17-4
payments to retire debt, reacquiring stock (treasury stock), and the payment of
dividends.
b.
The financing cycle interfaces with the expenditure cycle when cash is disbursed for
bond interest, the redemption of bonds, payment of cash dividends, and the purchase
of treasury stock.
17-11. The audit objectives for the financing cycle are:

Transaction Objectives
Occurrence. Recorded debt (EO1), interest cost (EO2), and equity (EO3) represent transactions that
occurred during the year.
Completeness. All debt (C1) and interest costs incurred (C2), and equity transactions (C3) that
occurred during the period were recorded.
Accuracy. Debt (VA1), interest costs (VA2), and equity transactions (VA3) transactions are accurately
valued using GAAP and correctly journalized, summarized and posted.
Cutoff. All debt (EO1 and C1), interest cost (EO2 and C2), and equity transactions (EO3 and C3)
have been recorded in the correct accounting period.
Classification. All debt (PD1), interest cost (PD2), and equity transactions (PD3) have been recorded in
the proper accounts.
Balance Objectives
Existence. Recorded debt (EO4) and equity (EO5) exist at the balance sheet date.
Completeness. All debt (C4) and equity (C5) is recorded at the balance sheet date.
Rights and Obligations. All recorded debt balances are the obligations of the entity (RO1), and equity
balances represent owners claims on the reporting entitys assets (RO2).
Valuation and Allocation. Debt (VA4), and equity (VA5) balances are properly valued in accordance
with GAAP.
Disclosure Objectives
Occurrence and Rights and Obligations. Debt (PD4) and equity (PD8) disclosures have occurred and
pertain to the entity.
Completeness. All debt (PD5) and equity (PD9) disclosures that should have been included in the
financial statements have been included.
Understandability. All debt (PD6) and equity (PD10) information is appropriately presented and
information in disclosures is understandable to users.
Accuracy and Valuation. Debt (PD7) and equity (PD 11) information is disclosed accurately and at
appropriate amounts.
17-12. a.
b.
There is considerable variation in the importance of long-term debt in financial

statements. In some companies with strong free cash flows, debt is immaterial. In
other companies, such as public utilities, long-term debt may be more than 50% of
total equities. Stockholders equity is clearly material to the balance sheet. The
income statement effects and the effect of dividends on the retained earnings
statement is often material. Inherent risk for financing transactions is generally
moderate as transactions occur infrequently.
Following are several examples of analytical procedures and how they might be used
to identify potential misstatements in debt financing transactions.
17-5
Ratio
Free Cash Flow
Interest Bearing Debt
to Total Assets
Shareholders Equity
to Total Assets
Comparing Return on
Assets with the
Incremental Cost of
Debt
Current Portion of
Debt and Dividends to
Cash Flow from
Operations
Times Interest Earned
Interest Expense to
Interest Bearing Debt
Audit Significance
Negative free cash flows indicate the need for, and approximate
amount of, expected financing to prevent drawing down on
cash or investments.
Provides a reasonableness of the entitys proportion of debt
that may be compared with prior years experience or industry
data.
Provides a reasonableness of the entitys proportion of equity
data.
If a company is able to generate a higher rate of return on
assets than its incremental cost of debt, this is a signal that an
entity may use debt financing to expand the assets and
earnings of the entity.
A test of the entitys ability to service its financing obligations.

Ratios less than 1.0 indicate potential liquidity problems.
A test of the entitys ability to generate earnings to cover cost of
debt service. Ratios less than 1.0 indicate that the entitys
earnings are insufficient to cover financing costs.
A reasonableness test of recorded interest expense that should
approximate the entitys average cost of debt capital.
17-13. Control risk as also low as financing transactions receive considerable attention from senior
management and the board of directors that carefully monitor the acquisition and retirement
of debt.
17-14. The functions that relate to financing cycle transactions include:
Authorizing bonds and capital stock
Issuing bonds and capital stock
Paying bond interest and cash dividends
Redeeming and reacquiring bonds and capital stock
Recording financing transactions
17-15. Because of the nature and materiality most types of long-term debt transactions, inherent
risk is often moderate to high for all related account balance assertions. Based on
consideration of these factors and any relevant control risk assessments, an appropriate level
of detection risk is determined for each significant assertion related to long-term debt
balances. Many auditors follow a primarily substantive approach to long-term debt because
of the efficiency and effectiveness of using confirmations to audit a small population size.
17-6
17-16. The substantive tests that apply to the existence or occurrence and valuation or allocation
assertions for long-term debt balances are.
EO
VA
Verify accuracy of balances, schedules, and
X
subsidiary ledgers (perform initial procedures)
Perform analytical procedures.
X
X
Vouch entries in long term debt and related income X
X
statement accounts
Review authorizations and contracts
X
X
Confirm debt with lenders and bond trustees
X
X
Recalculate interest expense
X
17-17. a.
b.
c.
In vouching entries to long-term debt accounts, the direction of the substantive test is
from recorded entries to supporting documentation. This test pertains to the existence
or occurrence, completeness, rights and obligations, and valuation or allocation
assertions.
In confirming debt, the auditor has direct communication with lenders and bond
trustees and the responses are returned directly to the auditor. This test relates to four
assertions: existence or occurrence, completeness, rights and obligations, and
valuation or allocation.
In recalculating interest expense, the auditor re-performs the computations made by
the client. This test relates primarily to valuation or allocation.
17-18. Inherent risk for stockholders' equity balances should be low. However, the acceptable level
of detection risk for the existence or occurrence and completeness assertions for capital
stock are likely to be high when the company uses a registrar and transfer agent. For the
other assertions, detection risk may be moderate. Again, many auditors follow a primarily
substantive approach to auditing shareholders equity because of the efficiency and
effectiveness of using confirmations (registrar or transfer agent) to audit a small population
size.
17-19. The substantive tests that apply to the existence or occurrence and completeness assertions
for stockholders' equity balances are
EO
C
Perform analytical procedures
X
X
Vouch entries to capital stock accounts
X
Vouch entries to retained earnings
X
Review articles of incorporation and bylaws
X
Review authorizations and terms of stock issues
X
Confirm shares outstanding with registrar and transfer agent
X
X
Inspect stock certificate book
X
X
Inspect certificates of shares held in treasury
X
X
17-7
17-20. Following a several examples of analytical procedures and how they might be used to
identify potential misstatements in shareholders equity transactions.
Ratio
Return on common
stockholders equity
Equity to total liability
and equity
Dividend payout rate
Earnings per share
Sustainable growth
rate
Audit Significance
Provides a measure of the rate of return generated on the
common shareholders investment. Auditors should understand
the competitiveness factors that allow a company to obtain
unusually high returns.
Provides a reasonableness of the entitys proportion of equity
data.
Auditors would normally expect low dividend payout rates for
high growth companies that need reinvested earnings to fund
investments in working capital and long-term assets.
Earnings per share is useful for comparisons with price per
share. This ratio can be compared with industry price earnings
ratios for reasonableness.
Provides an estimate of rate of sales growth that can be
obtained without changing the entitys profitability or financing
structure. The auditor should expect changes in the financing
structure when sales grow significantly faster than the
sustainable growth rate.
17-21. Various value-added services that the auditor might offer to a client related to the investing
and financing cycles include:
Benchmarking the return generated by investing activities against competitors.
Independent review of strategic plans for investing activities.
Explanation of the advantages and disadvantages of bank financing, mortgage financing,
lease financing, financing that may be available from insurance companies or other
entities, or various classes of preferred stock.
Many investments are accomplished through merger or acquisition. A CPA firm may
provide expertise in guiding a company through a merger or acquisition. This service
would include identifying possible acquisitions candidates, helping an entity evaluate the
potential benefits and risks associated with an acquisitions, as well as how to structure
the acquisition.
Comprehensive Questions
(Estimated time - 25 minutes)
17-22. The key internal controls related to Grant's property, equipment and related transactions that
Harris may consider in assessing control risk include the following:
Advance approval in accordance with management's criteria is required for property
and equipment transactions.
Approval authority for transactions above an established dollar value is required at a
higher level, such as the board of directors.
Property and equipment transactions are adequately documented.
17-8
There are written policies covering capitalizing expenditures, classifying leases, and
determining estimated useful lives, salvage values, and methods of depreciation and
amortization.
There are written policies covering retirement procedures that include serially
numbered retirement work orders, stating reasons for retirement and bearing
appropriate approvals.
There are adequate policies and procedures to determine whether property and
equipment are received and properly recorded such as a system that matches
purchase orders, receiving reports and vendors' invoices.
There are adequate procedures to determine whether dispositions of property and
equipment are properly accounted for and proceeds, if any, are received in
accordance with management's authorization.
A property and equipment subsidiary ledger is maintained showing additions,
retirements, and depreciation, and the ledger is periodically reconciled.
Property and equipment is physically inspected and reconciled at reasonable
intervals with independently maintained property and equipment records.
An annual budget is prepared and monitored to forecast and control acquisitions and
retirements of property and equipment.
Reporting procedures assure prompt identification and analysis of variances between
authorized expenditures and actual costs.
Property and equipment is protected by adequate safeguards.
Property and equipment is insured in accordance with management's authorization.
Documents evidencing title and property rights are periodically compared with the
detailed property records.
The entity employs internal auditors to test whether the internal control structure
policies and procedures are operating effectively.
17-9
17-23. a.
Category
Initial
Procedures
Analytical
Procedures
Tests of
Details of
Transactions
Tests of
Details of
Balances
Tests of
Details of
Accounting
Estimates
Tests of
Details of
Presentation
and
Disclosure
The following matrix identifies the substantive tests pertaining to property, plant and
equipment and the audit objectives pertaining to each.
Substantive Test
1)
Obtain and understanding of the entity and its environment and determine:
a) The significance of plant assets, and changes in plant assets, to the entity.
b) Key economic drivers that influence the entitys acquisition of plant assets.
c) Industry standards for the extent to which the entity is capital intensive and the
impact of plant assets on earnings.
d) Understand the degree to which the company has used variable interest entities
and operating leases to finance assets.
2) Perform initial procedures on plant assets balances and records that will be subjected
to further testing.
a) Trace beginning balance for plant assets and accumulated depreciation to prior
years working papers.
b) Review activity in general ledger accounts plant assets and depreciation expense
and investigate entries that appear unusual in amount or source.
c) Obtain client-prepared schedules of plant asset additions, retirements and
depreciation expense, and determine that they accurately represent the
underlying accounting records from which they were prepared by:
i) Footing and crossfooting the schedules and reconciling the totals with
increases or decreases in the related general ledger balances during the
period.
ii) Testing agreement of items on schedules with entries in related general
ledger accounts.
3) Perform analytical procedures:
a) Develop an expectation for plant assets using knowledge of the industry and the
entitys business activity
b) Calculate ratios:
i) Fixed asset turnover
ii) Depreciation expense as a percent of sales
iii) Repair and maintenance expense as a percent of sales
iv) Rate of return on assets
c) Analyze ratio results relative to expectations based on prior years, industry data,
budgeted amounts, or other data.
4) Vouch plant asset additions to supporting documentation.
5) Vouch plant asset disposals to supporting documentation.
6) Vouch a sample of entries to repairs and maintenance expense.
7) Vouch the recording of new capital lease and operating leases to underlying
contracts.
8) Inspect plant asset.
a) Inspect plant asset additions.
b) Tour other plant assets and be alert to evidence of additions and disposals not
included on clients schedules and to conditions that bear on the proper
valuation and classification of the plant assets.
9) Examine title documents and contracts
10) Evaluate the fair presentation of depreciation expense by evaluating the
appropriateness of useful lives and estimated salvage values.
11) Determine if any significant events have resulted in an impairment of the value of
plant assets.
12) Compare statement presentation with GAAP.
a) Determine that plant assets and related expenses, gains, and losses are properly
identified and classified in the financial statements.
b) Determine the appropriateness of disclosures related to the cost, book value,
depreciation methods, and useful lives of major classes of plant assets, the
pledging of plant assets as collateral and the terms of lease contracts.
c) Evaluate the completeness of presentation and disclosures for receivables in
drafts of financial statements to determine conformity to GAAP by reference to
disclosure checklist.
d) Read disclosures and independently evaluate their understandability.
All
VA4
EO1, EO4
VA4
VA4
All
EO1, VA1, PD1, EO4, VA4

EO1, C1, VA1, PD1
EO4
EO4, C1, C2, C4
RO1
VA5
VA6
PD4, PD7
PD4, PD7
PD5
PD6
17-10
b.
Item No.
1.
2.
3.
4.
Is Audit Adjustment
Reasons Why Audit Adjustment or Reclassification
or Reclassification
is Required or Not Required
Required?
Yes or No
Yes
Commissions paid to real estate agents are costs directly related to
the acquisition of the property and should be included in the land
cost. Costs of removing, relocating, or reconstructing property of
others to acquire possession are costs that are directly attributable
to conditioning the property for use and should be included in land
costs. An adjustment is required for these items so that total land
costs can properly be included in Property, Plant & Equipment.
No
No adjustment is required because clearing costs are costs that are
directly attributable to conditioning the property for use and should
be included in land costs which are part of Property, Plant &
Equipment.
Yes
Since clearing costs are costs of the land, amounts realized from the
sale of materials recovered, such as timber and gravel, should be a
reduction of the cost of the land and should not be recorded as other
income.
Yes
All costs relating to the purchase of machinery and equipment
should be capitalized. For purchased items such costs would
include invoice price, freight costs, and unloading charges. Royalty
payments, however, should not be included in the cost of the
machinery. Such payments should be charged to expenses as they
accrue. The machinery costs, other than royalty payments, should
be included in Property, Plant & Equipment.
17-24. (Estimated time - 20 minutes)

Substantive tests that Pierce should use in examining Mayfair's mobile construction
equipment and related depreciation would include the following:
Determine that the equipment account is properly footed.
Determine that the subsidiary accounts agree with controlling accounts.
Obtain, or prepare, an analysis of changes in the account during the year.
Determine that beginning-of-year balances agree with the prior year's ending balances.
Inspect documents in support of additions during the year.
Inspect documents in support of retirements during the year.
Analyze repairs and maintenance for possible reclassifications.
Determine the propriety of accounting for equipment not in current use.
Test the accuracy of equipment and accounting records by
o Selecting items from the accounting records and verifying their physical
existence.
o Selecting items of equipment and locating them in the accounting records.
o Evaluate the reasonableness of estimated lives and methods of depreciation used.
17-11
o Test the calculation of depreciation expense and accumulated depreciation

balance.
o Apply analytical procedures such as comparing depreciation expense to balance
sheet accounts for proper relationship and comparing the current year's
depreciation expense with prior year's depreciation expense.
o Evaluate the financial statement presentation and disclosures for conformity with
generally accepted accounting principles.
o Review insurance coverage.
(Note: Other possible tests in the chapter may also be used.)
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
a. Substantive Test
b. Financial Statement Assertion
Vouch entries to retained

earnings to board of director
minutes.
Vouch entries in long-term
debt accounts to board of
director minutes
Vouch to cash
disbursements journal and
recalculate bond interest
Vouch entries to brokers
advice
Inspect entries in cash
disbursements journal
Existence or occurrence, rights and

obligations, and valuation or
allocation
All except presentation
and disclosure
Vouch to board of director

authorization, and consider
confirming with transfer
agent.
Recalculate
interest expense
Inspect cash disbursements
journal entry, supporting
documentation and consider
confirming with bond
trustee.
Vouch to board of directors
minutes
Vouch to board of director
minutes and review
authorizations and terms of
c. Type of
Evidence
Documentary
Documentary
Existence or occurrence, valuation

or allocation
Mathematical

or allocation
or allocation
Documentary

or allocation
Documentary,
confirmation
Valuation or allocation
Mathematical
All except presentation

and disclosure
Documentary,
confirmation
Presentation and disclosure
Documentary
Documentary

Documentary
or allocation, rights and obligations,
and presentation and disclosures
17-12
a. Substantive Test
b. Financial Statement Assertion
c. Type of
Evidence
stock issues
a.
The substantive tests that Andrews should employ in examining the loans are as
follows:
Obtain an understanding of the business purpose of the loans made by the
president.
Confirm the loans, including terms, by direct communication.
Re-compute (or verify) interest expense and interest payable.
Re-compute the long-term and short-term portions of the debt.
Review minutes of meetings of the board of directors for proper authorization.
Verify payments made during the year and transactions after the year end.
Read (notes to) the financial statements and the loan agreements, and evaluate
the adequacy of disclosure and compliance with restrictions.
Obtain a management representation letter.
b.
Broadwall's financial statements should disclose the following information

concerning the loans from its president:
The nature of the related-party relationship
The dollar amounts of the loans
Amounts due to the president and, if not otherwise apparent, the terms and
manner of settlement.

The substantive tests that Jones should apply in examining the common stock and treasury
stock accounts are as follows:
Review the corporate charter to verify details of the common stock such as authorized
shares, par value, etc.
Obtain or prepare an analysis of changes in common stock and treasury stock accounts.
Compare opening balances with prior year's working papers.
Foot the total shares outstanding in the stockholders' ledger and stock certificate book.
Determine authorization for common stock issuance and treasury stock transactions by
inspecting the minutes of the board of directors' meetings.
Verify capital stock issuance by examining supporting documentation and tracing entries
into the records.
Verify treasury stock transactions by examining supporting documentation and tracing
entries into the records.
Examine all certificates canceled during the year.
Inspect all treasury stock certificates owned by the client.
Reconcile the details of the individual certificates in the stock certificate book with the
individual shareholders' accounts in the stockholders' ledger.
17-13
Compare the total in the stockholders' ledger and the stock certificate book to the
balance sheet presentation.
Re-compute the weighted average number of shares outstanding.
Compare the financial statement presentation and disclosure with generally accepted
accounting principles.
Determine the existence of and proper accounting for common stock and treasury stock
transactions occurring since year-end.
Obtain written representations concerning common and treasury stock in the client
representation letter.

The proposal for the limitation of procedure is not justified by the stated facts. Although the
transfer agent and the registrar know the number of shares issued, they do not necessarily know the
number of shares outstanding. Furthermore, the audit of capital stock includes more than
determining the number of shares outstanding. For example, the auditor must determine
what authorizations exist for the issuance of shares, what assets were received in payment of
shares, how the transactions were recorded, and what subscription contracts have been
entered into. Confirmation from the registrar could not help in determining these things. In
addition to confirmation from the registrar, the audit of capital stock might include the
following procedures for which the purposes are briefly indicated:
Examine the corporation charter to determine the number of shares authorized and the
special provisions relating to each class of stock if more than one class is authorized.
Examine minutes of stockholders' and directors' meetings to determine authorization for
appointments of the registrar and the transfer agent, and to determine authorization for
the issuance or reacquisition of shares.
Examine provisions relating to capital stock in the corporation law of the state of
incorporation to determine any special provisions such as, for example, those relating to
the issuance of no-par stock.
Analyze the capital stock accounts to obtain an orderly picture of stock transactions for use
as a guide to other auditing procedures and as a permanent record.
Trace the consideration received for capital stock into the records to determine what
consideration has been received and how it has been recorded.
Examine and schedule treasury stock and review entries for treasury stock to determine
the existence of treasury stock, as authorized, and to determine that a proper record has
been made.
Review registrar's invoices and cash disbursements to determine that original issue taxes
have been paid.
Compare dividends with stock outstanding at dividend dates to determine that dividends
have been properly paid and also to substantiate the stock outstanding.
Review subscription and option contracts, etc., to determine the facts in regard to
subscriptions and options and to determine that these facts have been properly recorded
and that they are adequately disclosed.
17-14
Cases
17-29. (Estimated Time 40 minutes)
a.
b.
The economic substance of the patent is the right to produce and sell a particular
drug if the drug becomes marketable. The primary issues associated with the
recording of the patent is the fair market value of the redeemable preferred stock. If
9% is a market interest rate and no discount or premium is appropriate, then the book
value of the patent is appropriately recognized at $10 million. The auditor also will
need to consider the appropriate amortization period. At this point in time the
appropriate amortization period might be 16 years. In the future, the auditor needs
be sensitive to impairment in the value of the patent.
Audit procedures performed in 20x0 to audit the patent would include:

Procedure
Assertion
Obtain and understanding of the business and industry and determine:

a) The significance of plant assets, and changes in plant assets, to the
entity.
b) Key economic drivers that influence the entitys acquisition of plant
assets.
c) Industry standards for the extent to which the entity is capital intensive
and the impact of plant assets on earnings.
Vouch the acquisition of the patent to supporting documentation and contracts
supporting the transaction and title.
All assertions
Evaluate the fair presentation of amortization expense by evaluating the

appropriateness of useful life.
Valuation or allocation
Determine the appropriateness of disclosures related to the cost, book value,

amortization methods, and useful life of patent.
Presentation and disclosure
Existence and occurrence,

rights and obligations,
valuation or allocation
c.
The economic substance of the redeemable preferred stock is debt. The security has a fixed
rate of return stated as a percentage of the par value of the security and it has a fixed
redemption date. Corporate holders of the redeemable preferred stock will enjoy a dividend
received deduction for tax purposes. The company has not appropriately classified the
security as the redeemable preferred stock is debt in economic substance and should be
reported as the last item in debt, prior to shareholders equity.
d.
Audit procedures performed in 20x0 to audit preferred stock would include:

Procedure
Obtain and understanding of the business and industry and determine:
a) The significance of sources of financing to the entity.
b) Key economic drivers that influence the entitys need for financing and
choice of financing.
c) Industry standards regarding the type of financing commonly used within
the industry.
Review authorization by the board of directors and contracts support the
transaction.
Confirm terms of contract with the holder of the redeemable preferred stock.
Recalculate interest expense
Assertion
All assertions
Existence and
occurrence, right and
obligations
All assertions
Valuation and allocation
17-15
Procedure
Compare statement presentation with GAAP.
a) Determine that long-term debt balances are properly identified and classified
in the financial statements.
b) Determine the appropriateness of disclosures concerning all terms, covenants,
and retirement provisions pertaining to long term debt.
Assertion
Presentation and
disclosure
c)
Evaluate the completeness of presentation and disclosures for receivables in

drafts of financial statements to determine conformity to GAAP by reference
to disclosure checklist.
d) Read disclosures and independently evaluate their understandability.
Professional Simulation
Audit
Procedures
FARS
Research
Situation
Audit Report
The following table explains the auditing procedures that should be performed associated with the
legend identified as a) through h).
Legend
a)
b)
c)
d)
e)
f)
g)
h)
Audit Procedure
Foot
Crossfoot
Traced beginning balance to prior years working papers and the general ledger.
Vouched additions to supporting documentation, e.g., vendors invoices, title reports, etc.
Vouched disposals to supporting documentation, e.g., bill of sale and cash receipts
Vouched reclassification to supporting documents, title reports and underlying
appraisals, showing the underlying value of the building.
Recalculated depreciation expense and evaluated the reasonableness of depreciation
methods, useful lives, and salvage values.
Vouched historical cost of disposal to underlying asset schedule with net book values.
FARS
Research
Situation
Audit
Procedures
Audit Report
The following quotes are from Statement of Financial Accounting Standards No. 13, Accounting for
Leases. Paragraphs 6 and 7 provide the basis for determining if the lease is a capital lease or an
operating lease.
17-16
6.
For purposes of applying the accounting and reporting standards of this Statement, leases are
classified as follows:
a.
7.
Classifications from the standpoint of the lessee:

i.
Capital leases. Leases that meet one or more of the criteria in paragraph 7.
ii.
Operating leases. All other leases.
The criteria for classifying leases set forth in this paragraph and in paragraph 8 derive from
the concept set forth in paragraph 60. If at its inception (as defined in paragraph 5(b)) a
lease meets one or more of the following four criteria, the lease shall be classified as a
capital lease by the lessee. Otherwise, it shall be classified as an operating lease. (See
Appendix C for an illustration of the application of these criteria.)
a.
b.
c.
d.
The lease transfers ownership of the property to the lessee by the end of the lease
term (as defined in paragraph 5(f)).
The lease contains a bargain purchase option (as defined in paragraph 5(d)).
The lease term (as defined in paragraph 5(f)) is equal to 75 percent or more of the
estimated economic life of the leased property (as defined in paragraph 5(g)).
However, if the beginning of the lease term falls within the last 25 percent of the
total estimated economic life of the leased property, including earlier years of use,
this criterion shall not be used for purposes of classifying the lease.
The present value at the beginning of the lease term of the minimum lease payments
(as defined in paragraph 5(j)), excluding that portion of the payments representing
executory costs such as insurance, maintenance, and taxes to be paid by the lessor,
including any profit thereon, equals or exceeds 90 percent of the excess of the fair
value of the leased property (as defined in paragraph 5(c)) to the lessor at the
inception of the lease over any related investment tax credit retained by the lessor
and expected to be realized by him. However, if the beginning of the lease term falls
within the last 25 percent of the total estimated economic life of the leased property,
including earlier years of use, this criterion shall not be used for purposes of
classifying the lease. A lessor shall compute the present value of the minimum lease
payments using the interest rate implicit in the lease (as defined in paragraph 5(k)).
A lessee shall compute the present value of the minimum lease payments using his
incremental borrowing rate (as defined in paragraph 5(1)), unless (i) it is practicable
for him to learn the implicit rate computed by the lessor and (ii) the implicit rate
computed by the lessor is less than the lessee's incremental borrowing rate. If both
of those conditions are met, the lessee shall use the implicit rate.
The lease described in the simulation meets all the criteria to be classified as an operating lease.
Also relevant to the evaluation of this lease is FIN 46. Shailer Enterprises is a variable interest
entity that should be consolidated ANUs financial statements. FIN 46 indicates that an enterprise
that consolidates a variable interest entity is the primary beneficiary of the variable interest entity.
The primary beneficiary of a variable interest entity is the party that absorbs a majority of the
entity's expected losses, receives a majority of its expected residual returns, or both, as a result of
17-17
holding variable interests, which are the ownership, contractual, or other pecuniary interests in an
entity. The ability to make decisions is not a variable interest, but it is an indication that the decision
maker should carefully consider whether it holds sufficient variable interests to be the primary
beneficiary. An enterprise with a variable interest in a variable interest entity must consider variable
interests of related parties and de facto agents as its own in determining whether it is the primary
beneficiary of the entity. ANU is it primary beneficiary that absorbs the majority of any losses to
the bank or Shailer Enterprises and received the expected returns if the value of the property
increases. The appropriate paragraphs of FIN 46 follow.
Shailer enterprises meets the following conditions of a variable interest entity based on paragraph 2
to the summary of FIN 46.
2.
The equity investors lack one or more of the following essential characteristics of a
controlling financial interest:
a.
The direct or indirect ability to make decisions about the entity's activities through
voting rights or similar rights
b.
The obligation to absorb the expected losses of the entity if they occur, which makes
it possible for the entity to finance its activities
c.
The right to receive the expected residual returns of the entity if they occur, which is
the compensation for the risk of absorbing the expected losses.
Paragraph 16 of FIN 46 defines a primary beneficiary.

16.
For purposes of determining whether it is the primary beneficiary of a variable interest

entity, an enterprise with a variable interest shall treat variable interests in that same entity
held by its related parties as its own interests. For purposes of this Interpretation, the term
related parties includes those parties identified in FASB Statement No. 57, Related Party
Disclosures, and certain other parties that are acting as de facto agents of the variable
interest holder. The following are considered to be de facto agents of an enterprise:
a.
b.
c.
d.
A party that cannot finance its operations without subordinated financial support
from the enterprise, for example, another variable interest entity of which the
enterprise is the primary beneficiary
A party that received its interests as a contribution or loan from the enterprise
An officer, employee, or member of the governing board of the enterprise
A party that has (1) an agreement that it cannot sell, transfer, or encumber its
interests in the entity without the prior approval of the enterprise or (2) a close
business relationship like the relationship between a professional service provider
and one of its significant clients.
Further, paragraph 14 of FIN 46 explains why the primary beneficiary should consolidate the
variable interest entity in the financial statements.
14.
An enterprise shall consolidate a variable interest entity if that enterprise has a variable
interest (or combination of variable interests) that will absorb a majority of the entity's
expected losses if they occur, receive a majority of the entity's expected residual returns if
17-18
they occur, or both. An enterprise shall consider the rights and obligations conveyed by its
variable interests and the relationship of its variable interests with variable interests held by
other parties to determine whether its variable interests will absorb a majority of a variable
interest entity's expected losses, receive a majority of the entity's expected residual returns,
or both. A direct or indirect ability to make decisions that significantly affect the results of
the activities of a variable interest entity is a strong indication that an enterprise has one or
both of the characteristics that would require consolidation of the variable interest entity. If
one enterprise will absorb a majority of a variable interest entity's expected losses and
another enterprise will receive a majority of that entity's expected residual returns, the
enterprise absorbing a majority of the losses shall consolidate the variable interest entity.
The economic substance of this lease arrangement is that Shailer Enterprises is dependent upon
ANU to obtain the loan, and ANU enjoys the benefits if the value of the real estate increases and
suffers the loss (through the contingent rent payment) if the value of the real estate decreases. As a
result, ANU should consolidate the financial statements of Shailer Enterprises as part of its own
financial statements.
17-19
Audit Report
Situation
Audit
Procedures
FARS
Research
INDEPENDENT AUDITORS REPORT
To the Board of Directors of Alpha Net Universal

We have audited the balance sheets of Alpha Net Universal as of December 31, 20x7 and 20x6, and the
related statements of income, stockholders equity and cash flows for the years then ended. These financial
statements are the responsibility of the Companys management. Our responsibility is to express an opinion
on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The Company has failed to consolidate the financial statements of Shailer Enterprises, a variable interest
entity, that, in our opinion, should be consolidated in order to conform with generally accepted accounting
principles. If these financial statements had been consolidated, property would be increased by $10 Million,
long-term debt by $9 Million, and Shareholders equity would be increased by $1 million.
In our opinion, except for the effects of not consolidating the financial statements of Shailer Enterprises as
discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material
respects, the financial position of Alpha Net Universal as of December 31, 20x7 and 20x6 and the results of
their operations and their cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States.
Signature
Date
17-20

Boynton SM Ch.17

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CHAPTER 17

AUDIT ING THE INVESTING AND FINANCING

2005, John Wiley and Sons, Inc.

Audit objectives for plant assets can be summarized as follows:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

The substantive tests that apply to three or more assertions are:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Inspecting plant assets generally involves physical inspection of additions to plant

In reviewing depreciation entries and computations, the auditor seeks evidence on

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

17-11. The audit objectives for the financing cycle are:

There is considerable variation in the importance of long-term debt in financial

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

A test of the entitys ability to service its financing obligations.

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

2005, John Wiley and Sons, Inc.

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Specific Audit Objectives

Solutions Manual to Modern Auditing: Copyright

EO1, VA1, PD1, EO4, VA4

2005, John Wiley and Sons, Inc.

17-24. (Estimated time - 20 minutes)

2005, John Wiley and Sons, Inc.

o Test the calculation of depreciation expense and accumulated depreciation

b. Financial Statement Assertion

Vouch entries to retained

Existence or occurrence, rights and

Vouch to board of director

Existence or occurrence, valuation

Existence or occurrence, valuation

Existence or occurrence, valuation

All except presentation

Presentation and disclosure

Existence or occurrence, valuation

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

b. Financial Statement Assertion

Broadwall's financial statements should disclose the following information

17-27. (Estimated time - 20 minutes)

2005, John Wiley and Sons, Inc.

17-28. (Estimated time - 25 minutes)

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Audit procedures performed in 20x0 to audit the patent would include:

Obtain and understanding of the business and industry and determine:

Evaluate the fair presentation of amortization expense by evaluating the

Determine the appropriateness of disclosures related to the cost, book value,

Presentation and disclosure

Existence and occurrence,

Audit procedures performed in 20x0 to audit preferred stock would include:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Evaluate the completeness of presentation and disclosures for receivables in

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Classifications from the standpoint of the lessee: